Sometimes what is necessary is not sufficient. That was one lesson learned following the bankruptcy of LandAmerica 1031 Exchange Services. This article discusses the series of LandAmerica bankruptcy decisions, describes the unanticipated hazards of relying on only one means of protection for clients who desire tax-deferred treatment of their real estate transactions, and explains how to provide more certainty and peace of mind for these clients.

Using a belt and suspenders is superfluous, right? Maybe, if your only risk is your pants falling down. But it might not be a redundant approach if you are potentially exposing large sums of money from the sale of a client’s real estate. One consideration of any real estate seller is the sale’s tax consequences. This applies particularly to sellers of business and investment real estate, whether the property is a small duplex or a large warehouse. Sellers of these types of properties often consider a tax-deferral method called a 1031 exchange. When completing an exchange, sellers and their counsel must strictly comply with the 1031 exchange rules, including ones pertaining to how funds from a property’s sale are handled as they go through the exchange process.

The Treasury Code and accompanying Internal Revenue Service (IRS) regulations lay out the exchange rules, including safe harbors: methods for proper handling of exchange funds.1 Using more than one of the safe harbors was previously thought of as a belt-and-suspenders approach, because one alone would “do the trick” for tax purposes and the safe harbors were not considered important for security-of-funds purposes. However, today, the LandAmerica bankruptcy case illustrates the importance to the security of exchange funds of using more than one approach.

How a 1031 Exchange Works

A 1031 exchange is also known as a tax-deferred exchange, a starker exchange, or a like-kind exchange. All refer to avoiding payment of capital gains tax upon the sale of property through a specific process authorized by I.R.C. § 1031. At the heart of any 1031 exchange is the exchange requirement. The exchanger must “roll” the investment from the property being sold into another property being purchased, called the replacement property. It is this continuation of the investment in property that allows for the exchanger to avoid the recognition of tax.

Here is a typical exchange scenario: Fred from Fred’s Furniture has decided it is time to expand his business, currently located in a small downtown building, owned by Fred, where the business has existed for more than 20 years. Moving to a bigger building will allow him to stock more inventory and take advantage of a new retail development with highway access. Fred’s accountant has informed him that if he sells his existing building without an exchange, he will face significant capital gains tax, making the move financially impossible. By selling the old building and purchasing the new building through a 1031 exchange, Fred can relocate without the tax payment.

One of the key requirements of the exchange process is that the exchanger cannot take receipt of the proceeds from the sale of the property. Any funds touched by the exchanger will be taxed and cannot be deferred. In other words, the seller cannot walk away from the closing table with a check for the sale proceeds. If the exchanger does so, then those funds will be taxed, because the seller has exchanged real estate for cash and not exchanged real estate for other real estate. For Fred and real-life sellers, the questions then arise as to where those funds can be held to comply with the tax rules, and how does one ensure the security of those funds.

The Qualified-intermediary Safe Harbor

The IRS regulations lay out safe-harbor methods that can be used by an exchanger to avoid taking receipt of the exchange funds during the exchange process.2 Most 1031 exchanges are completed using the qualified-intermediary safe harbor.3This method is usually used because the intermediary plays a few necessary roles during an exchange: 1) the intermediary holds onto the exchange funds, thereby avoiding receipt by the exchanger; and 2) the intermediary becomes the party with whom the exchanger exchanges or “trades” properties. This is a somewhat technical yet necessary function to effectuate a valid exchange.4 Thus, Fred can hire an intermediary to take receipt of the funds directly from the closing agent upon the sale of his old furniture store. The intermediary will hold those funds until Fred is ready to close on the purchase of his new store. Other safe-harbor vehicles include the qualified-escrow and the qualified-trust arrangements.5

The LandAmerica Bankruptcy

In 2008, LandAmerica 1031 Exchange Services Inc. (LES), one of the largest intermediaries in the nation at the time, and its parent company Land-America Financial Group Inc., a publicly traded company whose main business line was title insurance underwriting, filed for bankruptcy.6 The bankruptcy stemmed primarily from LES’s inability to fund its customers’ replacement-property purchases. LES had placed a portion of its exchange-fund holdings in auction-rate securities that became illiquid when the economy faltered in late 2008. As a result, many of the customers did not have funds available to complete their exchanges.7

LES’s arrangements for holding exchange funds varied by customer. The bankruptcy court placed the customers into classes based on the type of arrangement each customer had with LES. Three lead litigation cases came out of the bankruptcy court reflecting those classes of customers. Although they had different facts, the underlying legal issue in all the cases was whether or not the exchanger’s funds are part of the bankruptcy estate of LES or are the separate property of the exchanger. An exchanger does not want its exchange funds to become part of the intermediary’s bankruptcy estate. Not only would it lose part of its funds, but also, if the funds are tied up in bankruptcy, the exchanger would likely not meet the 180-day deadline to complete the purchase of replacement property. The outcomes of these cases depended largely on how LES held the funds and how the safe harbors were used.

The First Class of Customers. The case best illustrating the need for the approach of using more than one safe harbor is Millard.8 In Millard, the bankruptcy court issued a decision on a motion by one of LES’s customers (Millard Refrigerated Services Inc.) and similarly situated exchange customers. Millard sought return of its exchange funds, arguing that LES held those funds in trust for exchangers and that those funds should not be considered part of LES’s bankruptcy estate.

The bankruptcy court ruled that the exchange funds are part of the bankruptcy estate, leaving the exchange customers, much to their surprise, part of the class of unsecured creditors. The court noted the following:

The exchange agreement between LES and Millard did not expressly state that a trust relationship was created because the terms “trust,” “trustee,” and “beneficiary” were not used in the agreement and the agreement’s provisions limited LES’s duties, such that trustee-type fiduciary duties were not created. The court relied on Virginia law concerning the creation of trusts.

The parties were sophisticated and could have expressly created a trust if they had intended to do so.

The language in the exchange agreement stated that Millard shall have no “right, title or interest” in the exchange funds. (To have a valid exchange agreement, the agreement must limit the taxpayer’s right to receive, borrow, pledge, or obtain the benefit of the funds. Treas. Reg. § 1.1031(k)-1(g). Presumably the LES exchange agreement language was used to ensure compliance with this regulation, which is key to having a valid exchange. Unfortunately, the court found the language overbearing and relied on it in part to reach the conclusion that the funds became the property of LES’s bankruptcy estate.)

Millard’s funds were held in a master account with subaccounting for each exchanger’s funds as a means of segregation but not in separate accounts.

The Second Class of Customers. The outcome for the second class of customers was decided in Frontier,9 in which the court reached a conclusion similar to its conclusion in Millard. The Frontier exchangers’ agreement with LES was similar to that of the Millard exchangers, but their funds were commingled with other customers’ exchange funds, further weakening their argument that the funds were held specifically in trust for them.

Patrick T. Harrigan, Hamline 1995, is president and chief operating officer of Gain 1031 Exchange Co., a qualified intermediary for 1031 exchanges. He is a member of the Federation of Exchange Accommodators and was recently awarded the Certified Exchange Specialist® designation. He previously was vice president of a national exchange intermediary and senior vice president of a regional financial services company that provides 1031 exchange services. He has written and lectured extensively on tax-deferred exchanges for commercial real estate broker groups, attorneys, and trade publications. Reach him at com patrick.harrigan gainexchangecompany gainexchangecompany patrick.harrigan com.

The Third Class of Customers. The third class of exchangers achieved a much more favorable result. In Health Care REIT, the exchangers had an exchange agreement similar to the Millard and Frontier exchangers, but they had an additional safe harbor: they executed a qualified-escrow agreement using a third-party escrow agent to administer the holding of the funds.10 Also, their funds were held in segregated accounts in the name of each exchanger. These exchangers’ funds did not become part of the bankruptcy estate when the court approved a stipulation and settlement agreement set forth by the parties. Even though the court did not issue a memorandum opinion along with its order in this case, it is evident that the use of the additional, qualified-escrow safe harbor was a determining factor.

The amount of recovery for the customers from the Millard and Frontier classes has not yet been fully determined because the bankruptcy court approved a plan to distribute funds through a trust. The trust was created to pursue litigation on behalf of the customers to recover additional lost funds. Exchange customers in Wisconsin who were caught up in this bankruptcy have received, on average, about 25 cents on the dollar in exchange funds.

Recommendation for Attorneys Working with Exchange Clients

Lawyers advising clients completing a 1031 exchange should consider using a safe harbor such as a qualified escrow or qualified trust in addition to using a qualified intermediary. This belt-and-suspenders approach should reduce the risks to an exchanger’s funds in light of the LES bankruptcy case. The qualified escrow agent or trustee should be a party other than the intermediary, to separate the two roles. This separation will ensure that client funds are not withdrawn by the intermediary without the signature of all three parties: the exchanger, the trustee or escrow agent, and the intermediary.11

Exchange funds should be held in a deposit account at a financial institution separate from all other exchangers’ (and the intermediary’s) funds. Those funds should be in the name and tax identification number of the exchanger to provide further evidence that the funds are not the intermediary’s funds and are held for the sole purpose of a 1031 exchange. Additionally, exchange funds should not be placed into investments that can lose value, even if that means earning minimal interest on the account.

Few people would minimize the importance of protecting exchange funds during a 1031 exchange, including an attorney’s exchange client like Fred from Fred’s Furniture. Using a belt-and-suspenders approach will reduce the risk of clients’ exchange funds ending up around their ankles.